Q3 2003 "Flow of Funds"

UNEDITED (but I try to catch the conspicuous errors when I arise in the morning!)

Each week these days passes for a peculiar adventure through some serpentine
financial jungle. For the week, the Dow, S&P500, Transports, and Morgan
Stanley Cyclical indices advanced about 1.5%. The Utilities were unchanged,
and the Morgan Stanley Consumer index mustered a small gain. The broader market
was on fire, with the small cap Russell 2000 posting a 3% gain (up 6% y-t-d).
The S&P400 Mid-cap index gained 1.5%, increasing 2004 gains to 3%. The
NASDAQ100 added 2%, with y-t-d gains of 6%. The Morgan Stanley High Tech index
rose 4%, increasing 2004 gains to almost 10%. The Semiconductors added 2.5%
(up 10% y-t-d) and The Street.com Internet index 5% (up 8.5% y-t-d). The NASDAQ
Telecom index rose 3%, with 2004 gains of 11%. Since December 17th,
the Russell 2000 is up 9.6%, the Morgan Stanley High Tech index 16.7%, the
Semiconductors 17.3%, and the NASDAQ Telecom index 19.4%. For the week, the
Biotechs gained 4% (y-t-d up 6%). The Broker/Dealers surged 6% to an all-time
high, while increasing 2004 gains to 7%. The Banks added 1% this week to a
new all-time high. With gold dropping almost $20, the HUI gold index sank 11%.

January 16 - Financial Times (Alan Beattie): "The rush of investors into emerging
markets is in danger of suffering a swift and damaging reversal, the leading
association of global financial institutions has warned. In an unusually explicit
warning, the Institute of International Finance, which represents more than
300 of the world's largest banks and finance houses, said asset prices were
vulnerable after rising too far, too fast... The institute said net capital
flows to emerging markets last year reached $187.5bn, their highest since the
Asian financial crisis began in 1997, and forecast a further rise this year."

Freddie Mac posted 30-year mortgage rates sank 21 basis points last week to
5.66%, the lowest level since the week of July 11. Fifteen-year fixed mortgage
rates dropped 20 basis points to 4.97%. One-year adjustable rate mortgages
could be had at 3.62%, down 14 basis points to the lowest rates since the week
of July 18th.

In a development to monitor closely, mortgage applications surged last week.
Refi applications were up 25% for the week to the highest level in seven weeks.
Purchase applications jumped 11% to one of the highest levels ever. Purchase
applications were up 23.5% from one year earlier, with purchase dollar volume
up a notable 35.4%. The average purchase mortgage was for $206,200, with the
average adjustable-rate mortgage at $286,900.

Global Currency Watch:

The elusive dollar rally arrived abruptly this week. Curiously, the ECB this
week decided to "bite the bullet" and make comments supportive of a dollar
rally. This follows (coincidently?) a week of reportedly massive - and minimally
effective - Japanese dollar support. The dollar rallied strongly against the
euro over the past three sessions, and the dollar index posted a 3% gain for
the week. Nonetheless, the dollar recorded a slight decline against the yen.

January 15 - Financial Times (David Pilling and Barney Jopson): "Sadakazu
Tanigaki, Japan's finance minister, urged the US yesterday to take steps to
repair its trade and fiscal deficits, saying that concern over the two was
driving the dollar lower. Mr. Tanigaki said the twin deficits were undermining
faith in the US currency. 'It is being said that this is a concern linked to
the foreign exchange rate. If that is the case, efforts may be needed to improve
that.' Japan has intervened in foreign exchange markets to try to stop the
yen appreciating against the US currency but with limited success. Last year
it spent a record Y20,000bn ($188bn), three times the previous high, but failed
to hold the yen at Y115... Intervention has continued this year... Some
government officials have privately voiced concern over the effectiveness of
constant intervention. 'We can't continue this intervention policy indefinitely,'
said one official. 'But if we stop now the yen might soar. It's a catch-22.'"

The strongest currencies for the week included the Brazilian real, Russian
ruble, the Argentine peso, Mexican peso and the Indian rupee.

Commodities Watch:

The CRB index was walloped for 1.5% yesterday on dollar strength but then
gained virtually all of it back today (in spite of further dollar gains). The
CRB ended an impressively resilient week about unchanged. Crude oil closed
today above $35 a barrel, rising to the highest price since March.

January 16 - Bloomberg: "Crude oil rose after an Energy Department report
showed that U.S. inventories declined to the lowest level since September
1975."

January 16 - Bloomberg: "Oil inventories are plunging, leaving consumers
vulnerable to rising prices as world demand grows faster than expected,
according to the International Energy Agency, an adviser to 26 nations on
energy policy. Fuel and crude-oil inventories held in the 30 nations of the
Organization for Economic Cooperation and Development declined in November
by 860,000 barrels a day from October, to 2.53 billion, the Paris-based agency
said in a monthly report. The decline left stockpiles 95 million barrels
below the five-year average.

January 12 - Bloomberg: "China's crude oil imports last year rose 31 percent
to a record, the Ministry of Commerce said. China bought from abroad
91.12 million metric tons (670 million barrels) of crude oil last year...
The country's imports of fuels such as gasoline and diesel gained 39 percent
to 28.24 million tons."

Global Reflation Watch:

January 12 - UPI: "China's total trade volume hit $851.21 billion
last year, up 37.1 percent from 2002... Statistics show that in 2003
China had exports of $438.37 billion, up 34.6 percent from the 2002 level,
and had imports of $412.84 billion, up 39.9 percent from the 2002 level.
Last year's total increase over 2002 levels -- for both imports and exports
-- was $230.4 billion, or 37.1 percent. That makes 2003 the country's fastest
growing year since 1980."

January 12 - Bloomberg: "India's industrial production grew at its fastest
pace in three years in November as rising farm incomes and the cheapest
credit in three decades led consumers to buy homes, vehicles and other
goods."

January 15 - Bloomberg: "Indian equity funds last week had the largest weekly
inflow of new funds in at least two years as some overseas investors bet stocks
in Asia's third-biggest economy can extend last year's 73 percent surge."

January 16 - Bloomberg: "Argentina's consumer confidence climbed in December
to its highest level since the University Torcuato Di Tella began tracking
confidence levels in March 2001."

Domestic Credit Inflation Watch:

January 16 - Dow Jones: "Bond issuance should decline this year from the record
levels seen in 2002 and 2003, as the economy heats up and interest rates rise,
according to the Bond Market Association. The BMA sees bond issuance (excluding
Treasurys and agencies) totaling $3.05 trillion, compared with $4.96 trillion
last year - with the sharpest decline coming in secondary mortgage markets..."

January 15 - Dow Jones (Christine Richard and David Feldheim): "With the giant
mortgage market exerting an ever-greater influence on the Treasury market,
it's not surprising that Countrywide Financial Corp.'s (CFC) securities unit
was added this week to the prestigious list of primary dealers for U.S. Treasurys.
As a primary dealer Countrywide Securities Corp. joins 22 other institutions
that underwrite Treasury auctions and deal directly with the Federal Reserve
Bank of New York's open market desk. And with Countrywide's well-rounded presence
in the mortgage market, it's a unique addition to the roster of primary dealers.
The other 22 institutions on the list are best known either for their securities
businesses or for their commercial banking operations... Countrywide sold a
record $435 billion in mortgage loans in 2003, according to the company's fourth
quarter results

January 14 - Bloomberg: "A Manhattan apartment's average price fell 1.5 percent
in the last three months of 2003 from a record in the previous quarter, and
sales slipped 2.9 percent, as fewer New Yorkers offered their homes for sale,
a report showed. Prices declined to $903,259 from $916,959 and sales
dropped to 2,256 from 2,324, according to a report from Miller Samuel Inc.,
a residential appraiser, and Douglas Elliman, the city's
largest brokerage."

January 14 - Dow Jones (Christine Richard and Julie Haviv): "Cash-out refinancings
have been a dream come true for many homeowners and mortgage bankers. But some
of the cash individuals took out of their homes may be, in fact, a fantasy
as the booming market led some appraisers in the rush for business to overstate
home values. Exaggerated appraisal values have raised concerns at Fannie Mae,
the largest buyer of mortgages in the nearly $7 trillion mortgage market. That's
set off a scramble to reappraise property values that could leave banks on
the hook for inadequately backed loans sold to Fannie Mae. It also means individuals
may have borrowed against equity in their homes that doesn't exist. 'We have
seen a trend toward inflated appraisal values on cash-out refinancings,'
said Alfred King, director of communications at Fannie Mae.
' That has resulted in Fannie Mae requiring lenders to review loans for excessive
valuation.'"

Received this week from Citibank: "This tax season, make life simpler by paying
your taxes with your Citi/AAdvantage Card. It's fast, convenient and you'll
earn one AAdvantage mile for every dollar charged. What could be easier? ...So
paying your taxes can be simpler, stress-free and rewarding..."

December Advance Retail Sales were reported up a slightly less-than-expected
0.5% from November. But don't let that fool you. December Retail Sales were
up 6.7% from December 2002. December Producer Prices were up 4% from December
2002. Year-over-year PPI gains have not been stronger since January 2001.

The New York State Manufacturing index added almost 2 points to a better-than-expected
and record 39 points. The Philadelphia Fed index surged a much stronger-than-expected
6.7 points to 38.3 to the strongest reading since December 1993.

Our nation's Trade Deficit for November improved to $38.0 billion. Year-over-year,
Goods Exports were up 10.5% to $63.82 billion. Goods Imports were up 5.4% to
$107.42 billion. It would require Goods Exports to increase 68% to match Goods
Imports.

Interestingly, the University of Michigan survey of preliminary January confidence
surged 10.6 points to 103.2, the largest gain since November 1992. It is also
worth noting that the index is up 25.2% from January 2003. Current Conditions
were up 11.9 points to 108.9 and Economic Outlook was up 9.7 points to 99.5.

With stock prices up significantly over the past month and mortgage rates
down meaningfully, there should be no mystery surrounding the surge in consumer
confidence. I note that some analysts have averred that December's unimpressive
jobs data is indicative of a slowing economy. I would argue strongly that jobs
growth will not be a driving force for either the economy or financial markets.
The financial markets are today the horse and the economy the cart. As analysts,
our focus must remain on financial conditions, general liquidity, Credit availability
and lending growth.

Q3 2003 "Flow of Funds"

While it does require some thinking back, the third quarter was an extraordinary
period for the Credit system in several respects. The period demonstrated exceptional
growth; it marked the end of an historic mortgage refi boom; and there was
near dislocation in interest rate markets as yields spiked higher and some
key spreads and volatilities blew out to the widest levels since LTCM (it today
seems like such a long time ago). There was a major shifting of assets (and
liabilities) by players caught in the interest rate tumult. There was also
a marked deceleration and near stagnation of money supply growth, and with
it renewed talk of faltering liquidity, deflation and even a collapse in Credit.
With this in mind, I was especially excited by yesterday's (delayed) arrival
of the Fed's quarterly Z.1 report.

First of all, there was certainly no indication of any meaningful slowdown
in the historic Credit Bubble. Total Credit Market Debt (Non-financial and
Financial) increased at an 8.6% annualized rate during the third quarter to
$33.6 Trillion. Over the past year, Total Credit Market Debt increased $2.784
Trillion, or 9.0%. For comparison, Total Credit Market Debt increased $2.22
Trillion during 2002, $1.877 Trillion during 2001 and $1.792 Trillion during
2000. Since the beginning of 1998 (23 quarters), Total Credit Market Debt is
up a whopping 59% ($12.4 Trillion!).

Non-financial Borrowings (NFB) increased at a 7.4% rate to $22.0 Trillion.
Over four quarters, NFB has expanded $1.736 Trillion, or 8.6%. By sector, Federal
Government Debt expanded at an 8.2% rate to $3.95 Trillion, with a 12-month
rise of 10.3%. Total Household Debt increased at an 11.2% rate during the quarter
to $9.18 Trillion, with a 12-month rise of 11.2%. State & Local Governments
increased debt at a 10.5% rate during the quarter to $1.542 Trillion, with
a 12-month rise of 10.5%.

Lagging, Total Corporate Debt increased at a 3.4% rate during the quarter
to $7.33 Trillion, with a 12-month rise of 4.2%. It is worth noting that when
the government and household sectors are borrowing so aggressively, one would
expect resulting strong cash-flows (profits) to lessen corporate borrowing
requirements.

It is one of many curious facets of contemporary economic doctrine that Financial
Sector borrowings are deemed basically irrelevant; non-financial debt creation
is paramount and to examine Financial Sector debt amounts to mindless "double
counting." But to ignore financial sector liability creation and asset accumulation
is to disregard one of the key aspects of contemporary finance and the Great
Credit Bubble.

I strongly argue that financial sector expansion (including foreign institutions'
dollar asset accumulations) is the key liquidity-creating mechanism in today's
financial markets. It is surely much more useful to focus on financial sector
liabilities generally, rather than to fixate exclusively on "bank money" or
the money supply aggregates. In fact, in this environment the analysis of the
expansion of a broad range of financial sector liabilities is fundamental for
avoiding some rather major blunders. With this in mind, Financial Sector Borrowings
increased at a near record annualized $1.178 Trillion, or 10.9%, to $11.09
Trillion during the third quarter. Financial Sector Liabilities increased $1.08
Trillion, or 10.8%, over the past four quarters and have now doubled over the
past 23 quarters. This expansion is massive, unrelenting and historic, and
goes far in explaining rampant asset inflation and seemingly endless financial
market liquidity.

However, I'll begin by noting that Commercial Banking Total Assets expanded
at only a 1.2% annualized rate during the third quarter. This was down sharply
from the second quarter's 10.1% expansion and the weakest growth since the
Q1 2002 blip. Seasonally-adjusted "Net Acquisition of Financial Assets" actually
contracted at an adjusted annualized rate of $67.2 billion during the quarter.
And after gorging on Agency Debt for five quarters (up $226.7 billion, or 28%),
Commercial Banks reduced holdings by an annualized $268.8 billion during the
third quarter (as interest rates rose sharply, albeit temporarily). Bank Loans
expanded at about a 5% rate during the quarter. Notably, Commercial Loans contracted
by an annualized 9.0%, with these loans declining $103.5 billion (7.6%) y-o-y.
Conversely, Mortgage Loans expanded at a 12.9% pace during the quarter and
were up $301.9 billion (15.4%) y-o-y.

As for Commercial Bank liabilities, Checkable Deposits contracted at an annualized
pace of $152 billion, while Miscellaneous Liabilities expanded by an annualized
$219.3 billion. Foreign Banking Offices in the U.S. reduced financial assets
holdings by an annualized $128.2 billion, with the liability Federal Funds
and Securities RP (repurchase agreements) contracting by an annualized $100.4
billion.

Yet we certainly cannot nowadays associate slow bank asset growth with reduced
overall Credit expansion. Once again "saving the day," GSE Assets expanded
at a 21.4% rate during the quarter to $2.80 Trillion. At an unprecedented seasonally-adjusted
annualized increase of $568.9 billion, this was the strongest rate of GSE growth
since the anxious fourth quarter of 1999. As "Buyers of First and Last Resort" for
the banks, brokers, hedge funds and other speculators, the GSEs increased holdings
of mortgage-backed securities during the quarter by an annualized $542 billion
(45%). Over 12 months, GSE Assets inflated $345.6 billion, or 14.1%, compared
with the 2002 rise of $247 billion. GSE Assets have ballooned an astonishing
155% over 23 quarters.

Federally-related Mortgage Pools (GSE MBS) increased at a 9.9% rate during
the quarter to $3.37 Trillion, the strongest rate of growth in five quarters.
MBS was up 9.3% over the past year (up 85% over 23 quarters). Asset-backed
Securities (ABS) expanded at a 9.3% rate during the quarter to $2.56 Trillion,
with 12-month gains of 13.6% (up 159% over 23 quarters). Total "Structured
Finance" (combining GSE, MBS, and ABS assets) expanded during the quarter at
an annualized $1.23 Trillion, or 13.4%, to $8.76 Trillion. Over the past year, "Structured
Finance" has ballooned $938.3 billion, or 12.0% (up 123% over 23 quarters).

Finance Companies (including "captives") expanded assets during the quarter
at a notable annualized $366.9 billion, or 28%. To fund this expansion, Corporate
Bonds increased at an annualized $139.7 billion and Other Miscellaneous Liabilities
expanded at an annualized $257.9 billion. Money Market Funds contracted by
an annualized $223.1 billion, with holdings of Open Market Paper (commercial
paper) down by an annualized $167.9 billion. Miscellaneous Assets expanded
by an annualized $108.6 billion. Elsewhere, Real Estate Investment Trusts (REITs)
expanded assets at a 27% annualized rate to $108 billion.

The Federal Reserve increased its holdings by $9.9 billion during the quarter
to $778.9 billion, or 5.1% annualized. The Fed's balance sheet was up $68.7
billion, or 9.7% y-o-y. Over the past four quarters, Federal Reserve growth
has accounted for only about 6% of total financial sector expansion. .

Examining mortgage lending, Total Mortgage Borrowings increased at a 12.1%
rate during the quarter to $9.242 Trillion. Over four quarters, Total Mortgage
Credit surged $1.045 Trillion, or 12.8%. It is worth noting that Total Mortgage
Borrowings increased $288 billion during 1996 and $337 billion during 1997.
Since the beginning of 1998 (23 quarters), Total Mortgage Credit is up $3.98
Trillion (avg. $692 billion annually), or 76%. Total Household Debt was up
13.8% over the past year to $7.11 Trillion (up 78% over 23 quarters).

Examining third quarter government receipts and expenditures, Federal spending
was up 8.6% y-o-y, while receipts were down 4.1% y-o-y. State & Local government
spending was up 5.5% from third quarter 2002, while receipts were up 5.9%.
Total government debt increased at an annualized rate of $557 billion during
the quarter. Federal government debt increased at an annualized rate of $396
billion. State & Local debt increased at an annual rate of $161.3 billion.

It is also beneficial to take a close look at ballooning household assets
and liabilities. The Balance Sheet of the Household Sector (including non-profit
organizations) surpassed $51 Trillion for the first time during the third quarter.
Total Assets increased $802.2 billion during the quarter, or 6.3% annualized,
and were up $4.53 Trillion, or 9.6%, over the past year. The value of Household
Real Estate increased $290.8 billion during the quarter, or 8.2% annualized,
to $14.55 Trillion (up $1.07 Trillion, or 7.9%, over four quarters). And despite
massive borrowings, inflating values allowed Owners' Real Estate Equity to
increase $90 billion during the quarter to $7.9 Trillion. Total Financial Asset
values increased $434.7 billion, or 5.4% annualized, to $32.47 Trillion (up
$3.224 Trillion, or 11.0% over 4 quarters). Interestingly, Total Deposit
holdings actually contacted $4.4 billion to $5.17 Trillion. On the other
hand, Credit Market Instrument holdings jumped $61.9 billion, or 10.2% annualized,
to $2.49 Trillion. Holdings of Agency securities actually jumped $140 billion (to
$291.4 billion), easily the most conspicuous development with respect to household
investment preference.

And while we must wait impatiently until March for the release of the 4th quarter "Flow
of Funds" report, third quarter data provide us some very useful insight. As
for the almost four months of contracting money supply, unfolding during the
third quarter were some rather profound developments with regard to the nature
of financial sector liability creation. Commercial Banking Checkable Deposits
were in sharp decline ($152.4 billion annualized). Time and Savings Deposits
growth had slowed markedly, from an average annualized $371 billion over the
previous six quarters to only $43.9 billion during the three months ended September
30th. And Money Market Fund deposits were in sharp decline ($223.1 billion
annualized).

But we must not allow the stagnation and/or decline of key traditional money
supply components to draw our attention away from the continued major expansion
of Credit, along with an attendant huge expansion of financial sector liabilities
(predominately not elements of the money aggregates). Foremost, Total Agency
Securities (GSE debt and MBS) were issued at an unprecedented annualized rate
of $831.2 billion during the quarter. Treasury Securities were issued at an
annualized rate of $317.5 billion and State & Local debt at an annualized
$137.1 billion. Corporate and Foreign Bonds were issued at an annual rate of
$466.6 billion; New Equities at a rate of $137.4 billion. And Asset-backed
Securities were issued at an annual rate of $234.1 billion. Moreover, it appears
- especially in the case of agency securities - that households were increasingly
using liquid balances to acquire marketable securities directly, rather than
holding money fund or bank deposits.

The third quarter "Flow of Funds" confirms that we remain in the midst of
an unprecedented - truly historic - financial sector expansion and security
issuance boom. And as the melee of leveraged speculation and the general flight
to risk assets go to dangerous excess, the nature of financial claims inflation
and intermediation are altered momentously. Those today associating the declining "M's" with
deflation are missing profound developments in the U.S. Credit system and global
financial system.